Real Estate Woes Good News For Long-Term Investors
Posted on January 26, 2007
December 31, 2006, I opened my newspaper and was greeted with the headline “REAL ESTATE EXPECTED TO FLOUNDER IN 2007.” I’m sure this article wasn’t welcome news for many, but for long-term investors like me, it was a real shot in the arm. The Associated Press article by Rachel Konrad described the stagnation of the market in 2006 and offered a dire prediction of increasing woes that according to Diane Swonk, chief economist for Chicago based Mesirow Financial will be “�exacerbated by the gap between the buyer’s desire for bargains and the seller’s fantasy of what they once thought their homes would be worth.”
The article blames the ambitious building boom of recent years coupled with a slowdown brought on by rising interest rates as contributing factors that have caused the market to become flooded with unsold homes. It cites Moody’s Economy.com, a private research firm, as projecting the first full year decline in real estate prices since the Great Depression of the 1930s. So, with such a dismal outlook, how could this be good news for long-term investors?
In my books, audio programs and live seminars, I use an example that explains this phenomenon in simple terms. If you are in the shoe business, you can’t pay retail for you shoes and sell them for retail and stay in business. There’s no margin of profit to sustain the business. The same holds true for long-term investing in real estate. You can’t pay market value for properties and rent them for market value and stay in business. There’s no margin of profit. The difference is that the shoe business is short term and you see the effect immediately. You buy a pair of shoes for $100 and then sell them for $100, when the transaction is completed you have no money. You don’t have to do too many transactions like that to realize you have to buy the shoes at wholesale prices.
Real estate, on the other hand, is a long term investment and it often takes months or years before investors realize they paid too much for a property. But even then, when sales prices are soaring, inflation and time will often bail out bad decisions. During boom times, savvy long-term investors will often sit on the sideline and watch as novice want-to-be investors become caught up in the euphoria of a strong seller’s market and bid up prices beyond what any realistic investor could justify. They focus on the rising prices of the moment and grossly over pay as they chase the pot of gold at the end of the rainbow. The sad thing is that many of these inexperienced novices lose millions when the market cools and rapidly rising prices are no longer there to bail them out.
Thirty five years of buying investment real estate without ever having to sell a property has taught me some valuable lessons. The most important of which is learning to recognize the difference between investing and speculating. The next most important is the value of patience and persistence. Anytime you buy an investment property, it should generate enough income to cover all expenses and provide a reasonable return on your investment. If it doesn’t, you’re speculating. The key to long-term success is having the patience and persistence to keep looking and making offers until you can find such properties.
No one ever went broke because of a property they didn’t buy, but many have filed bankruptcy, been foreclosed upon or taken tremendous losses on properties for which they paid too much thinking rising prices would guarantee them a profit. Speculating in real estate is risky business and should only be engaged in by individuals who understand this and can bear the risk if the market turns sour. Knowledgeable investors know that the real estate market ebbs and flows just like most other segments of the economy. They make decisions based on current conditions, not the way they hope circumstances will be in the future.
Here’s a tip! When evaluating a potential investment property, start with the total rent you feel the property will bring today. From this total subtract an amount that will allow for vacancies based on current market conditions and come up with a realistic amount of total income the property will produce. From this total, subtract management fees, maintenance reserves, taxes, insurance, utilities and any other expenses you will incur while owning the property. What’s left is known as Net Operating Income (NOI). Unless you can structure a purchase scenario that will allow you to buy the property with this amount of money and have a comfortable cushion for unforeseen factors, you’re not investing, you’re speculating. “But,” people say. “It’s hard to find properties you can buy that way.”
That’s why the headline “REAL ESTATE EXPECTED TO FLOUNDER IN 2007″ is welcome news to long-term investors. When the market flounders, the number of buyer’s declines, renters increase and sellers become more flexible. This produces falling prices and rising rents which combine to create a bull market for investors. The weaker the market becomes, the more deals become available for investors. The key is having the patience to wait for the right opportunities to come along and the persistence to keep making offers until you find them.
Copyright 2007 by Mike Summey - Reprint with permission only.
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